Why should income investors be worried about the prospect of rising rates?
After more than three decades of declining interest rates, yields on longer-term Treasuries have approached historic lows. This affects income-oriented investors in a number of ways. One direct consequence of low yields is that investors currently earn relatively little interest on their fixed income investments. From this standpoint, a rise in interest rates would be beneficial, as higher income streams would result. However, the key risk relates to the capital loss that longer-term bonds could face as rates rise. Since price and yield are inversely related, in order for longer-term securities to yield more, the prices of those assets would need to fall.
We cannot predict when rates will rise. The United States could face the prospect of a slow growth, low inflation environment which could keep long-term rates low for years, as it did in Japan. However, with the low absolute level of long-term rates, we view the risks as skewed towards rate increases, as it is unlikely that long-term rates could become negative. We are also concerned that the unprecedented central bank interventions which have played an important role in producing the current rate environment may prove unsustainable.
How does the risk of higher rates fit into your investment process?
We consider ourselves bottom-up value investors, and as such, we focus on the specific attributes and valuations of the securities we are analyzing, rather than investing based on macro prognostications. Low rates have caused many rate-sensitive investments to appreciate substantially, reaching levels that we do not believe afford investors a valuation margin of safety. For instance, U.S. Real Estate Investment Trusts (REITs) have appreciated along with long-term bonds, and offer yields that are low by historical standards.
Our focus is on trying to produce an income stream that is meaningful and sustainable. Our goal is to grow the purchasing power of your clients’ capital and the income they can earn on their capital over time. Equities feature prominently as an engine of capital appreciation. An equity presence in an income portfolio is particularly important in this environment, where fixed income returns border on the confiscatory.
Today, longer-term Treasuries offer low real returns (returns in excess of expected inflation rates) and, as a result, also do not represent what we feel to be a compelling value. In a more normalized interest rate environment, long-term Treasuries could provide an attractive potential hedge against deflation. But in the current environment, this potential benefit of Treasuries is less interesting, in our view.